Saturday 28 November 2009 19.05 EST
First published on Saturday 28 November 2009 19.05 EST

At the end of October, the government of Dubai issued a prospectus to promote a $2.5bn Islamic bond, which contained a little-noticed but important clause.

In it, the government and the ruling family appeared to distance themselves from the state-owned companies behind Dubai's outlandish building boom and an acquisition spree that had included P&O, the British ports operator, department store Barneys New York and part of the firm that owns the London Eye. "The Dubai government," it said, "is under no obligation to extend support to any government-related entity". In other words, these companies, led by the largest, Dubai World, which benefited from implicit government guarantees when they were raising huge amounts of debt from western banks, were already being cut adrift.

The announcement on Wednesday that Dubai World, shouldering almost $60bn (£36.5bn) in debt, would seek a six-month moratorium on repayments sent shockwaves through world markets. Just hours earlier, the government, run by Sheikh Mohammed bin Rashid al-Maktoum, had raised $5bn from two banks for its own debts.

If anywhere is emblematic of the debt-fuelled extravagance of the past decade, it is surely Dubai, which strove to have the tallest, the biggest and the best of everything. If it collapsed, it would have profound effects on other emerging nations, the relationship between the west and the Middle East, and the ownership of scores of well-known businesses. In the worst case, it could wreck fragile confidence and pitch the world back into recession.

Dr Christopher Davidson, an expert on the region at Durham University, says that sovereign debt could be the credit crisis of the emerging markets. "It will make investors sit bolt upright. If Dubai can go down, perhaps others can as well. People might decide that markets like Dubai, where the governments are not fully transparent, are not worth a punt any more."

He says investors have been especially spooked because the Dubai ruler and officials had maintained in recent weeks that everything was fine. "They were just buying time until they could get a bailout from somewhere. The ruler has suffered a massive loss of legitimacy in the eyes of the business community. During the boom years, there was no separation between the government wealth and the companies' wealth – they were creaming it off. They can't now have it both ways." The sheikh, he says, could end up as "the most bankrupt person in the world".

Will Hadfield at the Middle East Economic Digest says there is widespread anger at the manner of the announcement, which came after markets in the Middle East had closed and at the start of the Eid al-Adha holiday. "There was an arrogance in making the biggest announcement to investors in years just when everyone was packing up for the holiday weekend."

The warning signs have been coming for some time. Property prices in the emirate had fallen 50% from their peak and follies including a set of man-made islands in the shape of the world map have been left half-built. According to the Bank for International Settlements, banks have claims totalling $123bn on debtors in the United Arab Emirates, $88bn of which are held by European banks and $50bn by UK banks alone.

There had already been signs in Britain, where it owns huge swathes of assets, that Dubai was unravelling. Last month Dubai World's investment arm, Istithmar World, sold two London properties – Marcol House in Regent Street and an office building in Newman Street – for a knockdown price of £10m. Istithmar had bought the properties for £90m, but was forced to sell when it found itself unable to pay the interest on a loan.

The ports division of Dubai World has also been reviewing its £1.5bn London Gateway Port project, some 25 miles east of central London, and last week secured a £300m rescue loan from the European Investment Bank.

Concerns have also been raised about the state of Travelodge, which is controlled by another investment business owned by Sheikh Mohammed, Dubai International Capital. Matthew Oakeshott of investment managers OLIM says: "Property investors are beginning to worry about companies like Travelodge which are backed by investors based in Dubai. They have been expanding very rapidly and a flood of their properties have hit the market recently." DIC claims to be unaffected by the crisis.

A deal with Dubai World for celebrity chef Jamie Oliver to build two restaurants at the Jumeirah Golf Estates and design kitchens for many of the homes in the area, which had no set budget limit, has also been cancelled.

Much will now depend on Abu Dhabi, Dubai's oil-rich neighbour, which will be concerned for the wider reputation of the United Arab Emirates. "Everyone is surprised that Abu Dhabi has allowed it to get to this stage," says Hadfield. "Abu Dhabi could easily afford to pay off its debts, but it could be that they want some of the more attractive assets in return – namely the ports business and the airline Emirates. Abu Dhabi and Dubai don't do each other any favours – Abu Dhabi sees Dubai as reckless and way too flashy. It will have to step in at some point. But presumably they want to extract a price."

Stephen Lewis of Monument Securities says clearing up the bad debts hidden throughout the world's financial system will put the brakes on recovery for a long time. "The latest Dubai problem is typical of the obstacles that stand in the way of sustained economic expansion, while the financial situation remains fragile," he says. "In simple language, the Dubai crisis is symptomatic of an economic depression."

As global investors wake up to this reality, he adds, "it would not take many more stories like that from Dubai to crack global confidence in paper assets."

After an explosive rally since March, many analysts were already warning that world equity markets looked overvalued. "Here we are now, four and a bit weeks from year-end, and there would be a desire to lock in profits. What Dubai does is accelerate that process," says Nick Parsons of NAB Capital. "Markets are going to be hugely volatile."

After decades of unprecedented growth and expansion Dubai's overheated economy is reaching its melting point. Dubai World, the state-owned real-estate and ports giant that has driven much of the economic growth in the city-state in recent years, has asked for a moratorium on its debt